Hitting the retirement-income ‘sweet spot’

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Study concludes only a small fraction of Canadians will have enough funds to maintain standards of living once they stop working

Just as astronomical telescopes allow us to glimpse the distant past, a “demographic telescope” allows us to peek into the distant future. What Canadian demographics are telling us is that only a small fraction of Canadians will retire with an adequate level of income in 50 years’ time.

What is the right level? For most people, it means having enough income to maintain their preretirement standard of living for the rest of their lives. Put another way, spendable income in retirement would be 100 per cent of what it was during one’s working years.

We’re unlikely to hit the 100-percent target every time, so let’s consider anything between 85 per cent and 115 per cent to be in the “sweet spot.”

There are two reasons why relatively few Canadians will hit that sweet spot. Some will not save enough. These are the “underachievers,” if you will, and no one will be surprised that there will be so many of them; news of a looming retirement crisis has been a popular theme in the media for some time. At the other end of the spectrum, some lucky workers – “overachievers” – will retire with income replacement rates in excess of 115 per cent.

What is surprising is that the proportion of both underachievers and overachievers will be so large. Such is the main conclusion coming out of a study commissioned by Morneau Shepell in 2016.

The study involved a projection of the entire population about two generations into the future. It was performed using Statistics Canada’s LifePaths model, a sophisticated microsimulation tool. Before taking into account the recent Canada Pension Plan (CPP) enhancement, the projections revealed that 49 per cent of today’s young Canadians would be retirement underachievers as defined above. The same projections estimated that 18 per cent would be overachievers and 33 per cent would land in the sweet spot.

An enhancement to the CPP was introduced in 2016 to address this issue, but the Morneau Shepell study suggests this will not fix our underfunded-retirement problems.

After building the CPP enhancement into our projections, 41 per cent of future retirees would still be underachievers.

In case you’re wondering why the net impact of the CPP enhancement will be so small, remember that the CPP (combined with the QPP in Quebec) represents just one pillar in Canada’s three-pillar retirement-income system.

The first pillar is Old Age Security (OAS) and it is gradually shrinking in real terms. Don’t expect its slow erosion to be reversed or even arrested. OAS hasn’t been improved since the early 1970s and a future government is more likely to consider cutting back OAS benefits further rather than introduce enhancements.

Pillar two, which consists mainly of RRSPs and workplace pension plans, is also under pressure. It will grow more slowly in the future because the higher contributions to the CPP will crowd out contributions to pillar three – a new mandatory savings plan. The CPP enhancement helps, but it barely does more than offset the shrinkage in the other two pillars.

Similarly, we cannot expect the CPP (and QPP) to be improved again any time soon. The 2016 enhancement was the first one in half a century and it took a remarkable level of co-operation among the finance ministers to make it happen. Another boost to the CPP is highly unlikely for at least a generation or two.

That leaves pillar three. A mandatory national saving plan could potentially help, but this is a nonstarter for the next few years, if not longer: Smaller businesses are still voicing their displeasure over the cost of the CPP enhancement so it would require a brave politician indeed to advocate another hefty payroll deduction.

But will 41 per cent of Canadians really be retirement underachievers? The ultimate percentage will probably be lower because many people might work longer when they realize they are falling short of their retirement sweet spot. LifePaths didn’t take later retirement into account. Also, LifePaths tends to underestimate income replacement rates because it doesn’t recognize the impact of inheritances that occur after retirement. It is unclear how much these two factors will help the underachievers, but an educated guess is that a third of the population will still be underachievers in 50 years’ time.

Given these considerations, the future of Canada’s retirement income system is coming into sharper focus. About a third of future retirees will be underachievers in terms of retirement income while another third will be overachievers.

That leaves a third of the population with retirement income in the sweet spot, more or less the same as without the CPP enhancement.

How can we address the retirement challenges that underachievers face? We could implement a voluntary national savings program like the United Kingdom’s NEST, where enrolment is automatic and individuals need to take action if they do not wish to participate.

Levelling the playing field when it comes to tax-assisted saving for retirement might also help. Or perhaps we should introduce a mandatory course in Grade 10 to ensure a minimal level of financial literacy. None of these things will happen, however, without a strong political champion.

Frederick Vettese is an actuary and partner at Morneau Shepell. The views expressed here do not necessarily represent the views of the firm.

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